WTF Is a Yield Curve?

August 14, 2019

Cheddar's Nora Ali explains the yield curve for treasury bonds, the figures that had traders spooked during the big stock selloff on Wednesday.

FULL TRANSCRIPT

Nora Ali: You've been watching the markets recently,

Nora Ali: you've probably heard a lot about yield curves.

Nora Ali: And on Wednesday, something happened that

Nora Ali: made the topic long watched by

Nora Ali: bond experts but rarely talked about by

Nora Ali: casual investors particularly interesting.

Nora Ali: The yield curve inverted,

Nora Ali: and it's really spooked the markets.

Nora Ali: But the big question is, why?

Nora Ali: But before we get into that,

Nora Ali: let's talk about what's the yield curve actually is.

Nora Ali: Basically, the plot of how much investors get

Nora Ali: paid or the yield for

Nora Ali: holding a bond for different lengths of time,

Nora Ali: otherwise known as maturities.

Nora Ali: So this is what a yield curve normally looks like.

Nora Ali: On the bottom are the time periods anywhere

Nora Ali: from one month all the way to 30 years,

Nora Ali: and then along the side are those yields.

Nora Ali: Since a treasury bond is essentially

Nora Ali: a loan to the US governments,

Nora Ali: there's usually less risk in lending out

Nora Ali: money for shorter periods of time.

Nora Ali: After all, you're probably pretty convinced

Nora Ali: that you're going to be paid back.

Nora Ali: You usually get paid a lower yield

Nora Ali: here for shorter maturities,

Nora Ali: and then looking out further in the future,

Nora Ali: say 10 or 30 years,

Nora Ali: you're much less certain of what could

Nora Ali: happen, new political policy's,

Nora Ali: a market crash, a war, you name it,

Nora Ali: so you'd usually demand to get paid much more for that.

Nora Ali: And that is why the curve usually slopes upwards.

Nora Ali: Now, let's take a look at

Nora Ali: the yield curve looks like today.

Nora Ali: Looks a little something like this.

Nora Ali: Investors seem much more

Nora Ali: concerned about the short term ability of

Nora Ali: the government to meet its debt obligations. But why?

Nora Ali: You can blame anything from the US-China trade war,

Nora Ali: to uncertainty over what

Nora Ali: the Fed will do with interest rates,

Nora Ali: to even questions about the campaign policies

Nora Ali: from all the people running in 2020.

Nora Ali: And with all the volatility in the stock market recently,

Nora Ali: investors are clamoring for

Nora Ali: safer investments like longer term bonds,

Nora Ali: that's sending those prices

Nora Ali: up and sending those yields down.

Nora Ali: Now, one particular part of

Nora Ali: the yield curve is particularly troubling

Nora Ali: and that's this section here between

Nora Ali: the 2 and 10 year Treasuries.

Nora Ali: Over the last couple of weeks,

Nora Ali: the line connecting those yields has been flattening.

Nora Ali: And here's another way to look at it.

Nora Ali: This is the difference here or spread

Nora Ali: between the 10 and 2 year Treasury yields.

Nora Ali: It's been falling sharply

Nora Ali: in August as you can see right there.

Nora Ali: And on Wednesday, it actually went negative.

Nora Ali: Here's that same spread since 2007.

Nora Ali: The last time it went below zero was

Nora Ali: right before the financial crisis.

Nora Ali: You might remember what that was like.

MALE_1: Now, tumbled more than 500 points

MALE_1: after two pillars of the Street tumbled over the week.

FEMALE_1: Lehman Brothers has filed for bankruptcy.

FEMALE_2: Stocks all around the world are

FEMALE_2: tanking because of the crisis on Wall Street.

George W. Bush: We're in the midst of a serious financial crisis.

Nora Ali: And the spread has dropped below zero a

Nora Ali: couple of times over the past several decades.

Nora Ali: So here's a look since the early '90s and

Nora Ali: the bar graph here is US GDP.

Nora Ali: You can see whenever the spread has gone negative,

Nora Ali: like there and there,

Nora Ali: so does GDP, meaning the economy goes into recession.

Nora Ali: So this here was the financial crisis,

Nora Ali: and this here was the dot-com bust.

Nora Ali: Neither was very fun for anyone

Nora Ali: whether they were in the stock market or not.

Nora Ali: On average, you can see the recession about two

Nora Ali: years after the yield curve flip flops.

Nora Ali: Now, it's probably too soon to say that

Nora Ali: this week's inversion means

Nora Ali: the economy is definitely going to crash,

Nora Ali: but the bond markets certainly seem worried.

Nora Ali: And if things continue on the current route,

Nora Ali: it could have a big impact on investors,

Nora Ali: the global economy, and even the 2020 race.

Nora Ali: Regardless of the actual economic or political outcome,

Nora Ali: an inverted curve could yield some interesting results.